Exchange rates

The currency is demanded by anyone who needs to pay in it and supplied by anyone who needs to sell it:

A rightward shift in demand, or a leftward shift in supply, makes the currency appreciate. Relatively high inflation works the other way: exports become less competitive, so demand for the currency falls. It is ordinary demand and supply, with the currency as the good.

• Floating — the market sets the rate. A rise is an appreciation, a fall a depreciation.
• Fixed — the central bank holds the rate against another currency, buying its own currency with reserves to support it and selling to hold it down. A deliberate change is a revaluation or devaluation.
• Managed float — the market sets the rate, but the central bank intervenes, or uses interest rates, to limit swings.

A fixed rate gives certainty to traders but ties the hands of monetary policy and needs reserves. A floating rate adjusts automatically but can be volatile.

• Exports become cheaper in foreign currency, so export volumes tend to rise.
• Imports become dearer in the home currency, so import volumes tend to fall.
• Inflation rises: dearer imported goods and raw materials push up costs (cost-push) and stronger net exports raise aggregate demand.
• The current account may improve — but only if demand for exports and imports is price elastic enough.

An appreciation does the reverse: cheaper imports help hold down inflation, while exporters lose competitiveness. The link to aggregate demand runs through (X − M).

A depreciation improves the current account only if the combined price elasticities of demand for exports and imports are greater than 1 (in absolute value). If demand is inelastic, the country sells only slightly more exports and still pays more for its imports, so the deficit widens.

The J-curve follows from elasticity rising with time. Straight after a depreciation, contracts are fixed and habits slow to change, so demand is inelastic and the current account worsens. As buyers switch, demand becomes more elastic, the Marshall–Lerner condition is met, and the balance improves — tracing a J. Both ideas are A Level content.

1. 1.Reading the rate the wrong way round.

   If £1 buys fewer dollars, the pound has depreciated — even though the dollar figure fell. Always say which currency you are describing.

2. 2.Assuming a depreciation always improves the current account.

   Only if demand is elastic enough (Marshall–Lerner), and often only after a delay (the J-curve).

3. 3.Using devalue for a floating currency.

   Devaluation and revaluation are deliberate changes to a fixed rate. A floating rate depreciates and appreciates.

4. 4.Forgetting the capital account.

   Interest rates and investment flows move currencies as much as trade does. A rise in interest rates attracts inflows and causes appreciation.